Unit 3-Financial Statement Analysis

UNIT 3: FINANCIAL STATEMENT ANALYSIS
Contents
Aims and Objectives
Introduction
Importance of Financial Statements
Uses of Financial Statements
Financial Analysis
Objectives of Financial Analysis
Types of Financial Analysis
Techniques of Financial Analysis
Summary
Answers to check Your Progress
Model Examination Questions
References
3.0 AIMS AND OBJECTIVES
This unit aims at presenting the term financial statements, importance, objectives, uses, financial
analysis meaning, importance and techniques of financial analysis.
After going through this unit, you shall be able to:

 understand the financial statements
 list the users of financial statements
 explain the terms analysis and interpretation
 identify the techniques of financial analysis
3.1 FINANCIAL STATEMENTS
In financial accounting, you have learned the process of preparation of financial statements.
Financial statements are the end products of accounting system. The two basic financial
statements required to be prepared for the purpose of external reporting are balance sheet and
income statement. For internal purposes of planning, decision making and control much more
information is contained in Balance sheet and Income statement.
I. Balance Sheet:
This is one of the important financial statements. It indicates the financial position of an
accounting entity at a particular, specified movement of time. It is valid only for a single day, the
very next day it will become obsolete. It contains the information about the resources,
obligations of a business entity and the owners’ interest at a specified point of time.
II. Income statement:

This report has greatest importance to the users of financial statements. It is a performance report
recording the changes in income, expenses, profit, and losses as a result of business operations
during the year between two balance sheet dates. The income statement is valid for the whole
year.
3.2 IMPORTANCE OF FINANCIAL STATEMENTS
Financial statements are the index of the financial affairs of a company. To the owners of the
company, they reveal its progress as evidence by earnings and current financial condition; to the
prospective investors they serve as mirror reflecting potential investment opportunity; to the
creditors they reflect the credit worthiness; labor unions are able to know the fair sharing of
bonus; the economist can judge the extent to which the current economic environment has
effecting its business activity; to the government the financial statements offer a basis of
taxation, control of costs, prices and profits and; to the management they reveal the efficiency
with which business affairs are conducted.
3.3 USERS OF FINANCIAL STATEMENTS
The following are interested in financial statements

1. Owners: The owners of a business unit have primary concern in operational and financial
results of the company. They wanted to know how safe their investment is and how
effectively it is being used. They expect periodical reports from the directors who are the
custodians of their money.
2. Managers: The managers are entrusted with the financial resources contributed by the
owners and other suppliers of funds for effective utilization. In their pursuit to take the
company to the destination of wealth maximization and maximization of economic welfare
of owners, the managers take several decisions. If their decisions are to be right and timely,
they require relevant financial information.
3. Creditors: The money suppliers are known as the creditors. They are interested in short-run
periodical payment i.e., payment of interest and in long-run to get back their money. It may
include the trade credits also. Thus, financial statements are highly useful.
4. Prospective Investors: Depending upon the financial performance, their financial
soundness and professional way managing the business activities may retain the interest of
existing stock holders and attract the potential prospective stock holder, who has the
inclination to invest their surplus or savings. The only basis for them to estimate the
financial position is company’s financial information i.e., income statement and balance
sheet.
5. Employees and Trade Unions: The financial statements are used by the employees
working in the company. It will help them to understand the earning capacity of the firm
and the amount spent on welfare, bonus fringe benefits, working conditions etc. The trade
unions will have better bargaining edge, when it has full information about the financial
data.
6. Consumers: The customers are also interested in the financial statements of a company.
Since, they are the one who is going to bear the cost of goods or services provided by a
company. A realistic appraisal of the firm activities through financial statements would
enable them to know whether they are over priced or exploited by being charged unduly
high rates/prices.
7. Government: It may be seen all over the world today that the governments as the
custodians of general public have assumed a dynamic role in shaping the economic
activities to take their own course in the hands of a few, self-interested capitalists, the
governments have started planning, regulating and controlling the economic affairs of the
country in a systematic way. All these efforts to be fruitful require information about the
economic activities of individual organizations. The financial statements of individual
companies serve as a source of information on the basis of tax levies, granting subsidies or
loans, imposing controls, fixing prices, offering protection or even nationalization, taking
over managements etc. the government uses the financial statements of the business unit as
a source.
3.4 FINANCIAL ANALYSIS MEANING AND IMPORTANCE
Financial statement analysis is a process of synthesis of summarization of financial statements

and operative data (presented in financial statements) with a view to getting an insight into the
operative activities of a business concern. It is a technique of investigating the financial positions
and progress of the unit. By establishing some relationship between balance sheet and income
statement, analysis attempts to reveal the meaning and importance of various items contained in
the financial statements. An analysis of financial statements gives a detailed account of business
operations and their impact on the financial health of the company.
For the purpose of financial analysis, we have to re-organize and re-arrange the data contained in
financial statements. The data may be grouped and re-grouped on the basis of resemblances and
affinities into categories of a few principal elements. These categories are clearly defined so that
their computations can be readily made. Through such classification and re-classification the
financial statements will be recast and presented in a condensed form. The changed arrangement
of items will be different form the original financial statements.
The analysis of financial data i.e., classification of the data into groups and sub-groups and
establishment of relationships among then, is followed by interpretation. The term interpretation
means explaining the meaning and significance of data. So simplified. It involves drawing
inferences from the analyzed data about the different aspects of the operational and financial
results of the business and its financial health.
Analysis and interpretation are closely inter-linked. They are complementary to each other.
Analysis without interpretation is useless and interpretation without analysis is impossible. But,
generally, the term analysis is used to include interpretation as well since, analysis is always
aimed at interpretation of the relationships that are established in the course of analysis. Thus, it
can be stated that analysis involves compilation, comparison and study of financial and operative
data and preparation, study and interpretation of the same.
3.5 OBJECTIVE OF FINANCIAL ANALYSIS
The main objective of financial analysis is to reveal the fact and relationships among the
managerial expectations and the efficiency of the business unit. The financial strengths and
weaknesses, its credit worthiness can also be known through such analysis. The safety of funds
invested in the firm, the adequacy or otherwise of its earnings, the ability to meet its obligations
etc. can also be examined through an analysis of their financial statements.
Of course, the financial analysis reveals only what has happened in the past. But, we can predict
future basing on past.
The management of the business unit is concerned; analysis can be used as a means of self-
evaluation. Through analysis the banker can assess the liquidity positions of the client firm and a
creditor can determine the credit worthiness. Analysis of financial statements helps an investor in
knowing the safety of his funds and the possible returns on the same. The bond holders can know
whether the income generated by the firm would provide sufficient margin to pay interest as well
as principal on maturity. Through an analysis of financial statements of firms, an economist can
gauge the extent of concentration of economic power and lapses in the financial policies perused.
The employees and trade unions can know how the firm stands in relation to labor and its
welfare. The analysis provides a basis to the government relating to licensing controls, price
fixation, ceiling of profits, dividend freeze, tax subsidy and other concessions.
3.6 TYPES OF ANALYSIS
The financial analysis can be broadly divided into two

I) external analysis and
II) internal analysis
External Analysis: This kind of analysis will be undertaken by the outsiders of the business unit.
These outsiders include investors, creditors, money suppliers, government and labor unions.
They do not have the access to the records of the company and depend on the published financial
statements and other information which the company furnishes.
Internal Analysis: This analysis is done by persons within the organization. They will have the
access of data i.e., the records of accounting and other information related to the business. They
include executives or employees of the organization.
Check Your Progress –1
1. What is analysis of financial statements?

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2. Analysis which is done by the persons within the organization is called.
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3. Name the financial statements.
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4. List the users of financial statements.
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3.7 TECHNIQUES OF FINANCIAL ANALYSIS
In the process of financial analysis various tools are employed. The most prominent amongst
them are listed as below:
1. Comparative statements
2. Common size statements
3. Trend Analysis
4. Ratio Analysis
5. Fund flow and cash flow analysis
Comparative Statements: Comparative statements are prepared to provide time perspective to

the consideration of various elements of operations and financial position of the business
embodied in the statement. Here, the figures for two or more periods are placed side by side to
facilitate comparison. In addition to absolute figures the ratios constructed from the financial
statements are also presented in the form of comparative statements. Both, balance sheet and
income statement are presented in the form of comparative statements.
Common Size Statements: Under this technique the individual items of income statement and
balance sheet are expressed as percentages in relation to some common base. In income
statement, sales are usually taken as hundred and all items are expressed as percentage of sales.
Similarly, in balance sheet the total of assets or liabilities treated equivalent to hundred and all
individual assets or liabilities are expressed as percentage of this total.
Trend Analysis: It is highly helpful in making a comparative study of the financial statements
for several years. The calculation of trend percentages involves the calculation of percentage
relationship that each item bears to the same item in the base year. Any year may be taken as
base year. Usually, the first year will be taken as the base year. Any intervening year may also be
taken as the base year. Each item of the base year is taken as 100 and on that basis the percentage
for each of the item of each of the years are calculated. These percentages can also be taken as
the index numbers showing the relative changes in the financial data over a period of time.
Ratio Analysis: Ratio analysis is a tool which establishes a numerical relationship of between
two figures normally expressed in terms of percentage. This has been discussed in detail in the
next unit.
Fund flow and Cash flow Analysis: The changes that have taken place in the financial position
of a firm between two dates of balance sheets can be ascertained by preparing the fund flow
statement which contains the sources and uses of financial resources. This is a valuable aid to
finance manager, creditors and owners in evaluating the uses of funds by a firm and in
determining how these uses are financed. This statement also helps to assess the growth of the
firm and its resulting financial needs to decide the best way to finance those needs.
Cash flow statement summaries the causes of changes in cash position between two dates of two
balance sheets. It indicates the sources and uses of cash. This statement is similar to statement
prepared on working capital basis, except that it focuses attention on cash instead of working
capital.
3.8 SUMMARY
The term “Financial Statements” includes balance sheet and income statement. The former one
reflects on the financial soundness of a business unit as on a particular date, the later one
provides the profit/loss made during a particular year. There are various people interested in
financial statements like owners, manages, creditors, consumers, government, employees etc.
Financial analysis is a process evaluating the soundness of a business unit from the point of view
of all parties interested in the affairs of the business. Different people may use different tools to
suit their individual purpose.
3.9 ANSWERS TO CHECK YOUR PROGRESS
1. I. Analysis is a process of summarization of financial statements with a view to getting an

insight into the operative activities of a business unit.
II. Internal analysis
III. Balance sheet and income statement are the financial statements.
IV. Owners, managers, creditors, government, employees, trade unions etc.
3.10 MODEL EXAMINATION QUESTIONS
1. State the objectives of financial statements.

2. Distinguish between balance sheet and income statement.
3. Who are the users of financial statements?
4. What is meant by financial analysis?
5. Differentiate between analysis and interpretation.
6. List out the techniques of financial analysis.
3.11. REFERENCES
 Kuchhal S.C. : Financial management, Chaitanya Publishing House Allahabad.

 Pandey IM. : Financial management, Vikas Publishing House Put Ltd.
New Delhi.
 Brigham EF : Fundamentals of Financial Management Dryden Press, Chicago
 Gitman L.J : Principles of Managerial Finance Harper Row, New York.
 Prasanny Chandra: Financial Management Theory and Practice Tata McGraw Hill,
New Delhi.
UNIT 4: RATIO ANALYSIS
Contents
Aims and Objectives
Introduction
Meaning of Ratio and Ratio Analysis
Importance of Ratio Analysis
Limitations of Ratio Analysis
Classification of Ratios
Leverage Ratios or Capital structure Ratios
Coverage Ratios
Liquidity Ratios
Activity Ratios
Profitability Ratios
Summing Up
Answers to Check Your Progress
Model Examination Questions
Recommended Books
4.0 AIMS AND OBJECTIVES
This unit aims at discussing the meaning, importance and limitations of ratio analysis. It also
explains the different ratios and their uses.
After reading this unit, you will be able to:

 grasp the significance of ratio analysis
 understand the limitations of ratios
 classify the ratios
 calculate the ratios and interpret the different kinds of the specific purposes.
4.1 INTRODUCTION
The preceding unit is about the meaning and importance of financial statement analysis, and also
the various tools or techniques of financial analysis including the simple and commonly used
tools of analysis, viz., comparative statements and common size statements. But these simple
tools will not be helpful to the analyst to make out the firm’s financial position and performance.
For a meaningful and realistic assessment of the position and performance of the firm the
analysis (analyst) should try to establish and evaluate the relationship between different
component items of the basic financial statements, i.e., Balance Sheet and Income Statement.
Ratio analysis will be found useful in this regard. Ratio analysis has become the most widely
used and powerful tool of financial analysis. The importance of ratio analysis is so much that
sometimes ratio analysis is regarded as a synonym to the financial analysis.
4.2 MEANING OF RATIO AND RATIO ANALYSIS
The term, ‘ratio’, refers to the numerical or quantitative relationship between items or variables.
It shows an arithmetical relationship between two figures. It is also defined as “the indicated
quotient of two mathematical expressions” and as “the relationship between two or more things”.
The relationship between two accounting figures expressed mathematically is known as
‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are generally expressed in
three ways. It may be a quotient obtained by dividing one value by another. For example, if the
current assets of a business on a particular date are Birr 200, 000 and its current liabilities Birr
100, 000 the resulting ratio would be Birr 200, 000 divided by 100, 000 i.e., 2:1. The ratio can be
expressed as a percentage as well. Taking the same particulars, it may be stated that the current
assets are 200% of the current liabilities. Sometimes ratios are expressed as so many ‘times’ or
‘fraction’: for example, the current assets may be stated as being double the current liabilities or
current liabilities was half of current assets.
Ratio analysis is the process of computing, determining and interpreting the relationship between
the component items of financial statements.
4.3 IMPORTANCE OF RATIO ANALYSIS
Ratio analysis is an extremely useful and the most widely used tool of financial analysis. It
makes for easy understanding of financial statements. It facilitates intra-and inter-firm
comparison. Ratios act as an index of the efficiency of the enterprise. A study of the trend of
strategic ratios helps the management in planning and forecasting. Ratios help the management
in carrying out its functions of coordination, control and communication. The analysis of ratios
may reveal maladjustments in planning, organizing, coordinating and monitoring different
activities of an organization. It will help to identify the specific weak areas, causes thereof and
type of remedial actions called for. A purposeful ratio analysis helps in identifying problems
such as the following and in finding out suitable course of action.
(a) Whether the financial condition of the firm is basically sound,
(b) Whether the capital structure of the firm is appropriate,
(c) Whether the profitability of the enterprise is satisfactory,
(d) Whether the credit policy of the firm is sound, and
(e) Whether the firm is credit worthy.
In short, through the technique of ratio analysis the firm’s solvency both long and short term
efficiency and profitability can be assessed.
4.4 LIMITATIONS OF RATIO ANALYSIS
At the outset it should be noted that ratio analysis is not an end in itself but a means to the
answering of specific questions which the users of the financial statements have in relation to the
financial condition and results of operations of the firm.
Ratios are derived from financial statements. The financial statements suffer from a number of
limitations and ratios which are derived form these statements are also subject to these
limitations.
Ratios are meaningless, if detached form their source.
Ratios, as they are, are not of much significance. They become useful only when they are
compared with some standards.
Ratio analysis should be made with caution in the case of inter-firm comparison. Unless the
firms in question follow identical accounting methods for items like depreciation, stock
valuation, deferred revenue expenditure, the writing off of capital items, etc., ratios will not
reflect the figures which are truly comparable.
No ratio may be regarded as good or bad as such. It may be an indication the firm is weak or
strong, not a conclusive proof there of.
Ratio analysis may give misleading results if the effect of changes in price level is not taken into
account.
No ratio analysis can be meaningful unless the questions sought to be answered are clearly
formulated.
The nature of the business (whether trading or manufacturing) and the industry’s characteristics
which affect the figures in the financial statements and their inter-relationships should be clearly
understood and born in mind in order to made meaningful ratio analysis.
The social, economic and political conditions which form the background for the firm’s
operations should be understood so as to make ratio analysis meaningful.
These limitations, to a considerable extent, can be eliminated or corrected:

1) if the analysis is related to one firm over a period of time;
2) if the analysis is limited to a few well chosen ratios which can answer specific questions;
3) if the results of the firm are compared with suitable norms or standards;
4) if the ratios are used primarily for the identification of areas for further managerial
analysis and formulation of alternatives available to the management in solving such
problems;
5) if the ratios are interpreted in the light of social, political, economic, technological and
business conditions under which the firm operates.
If ratio analysis is done mechanically it will be not only misleading but also positively
dangerous. If it is used with a measure of caution, reason, and logic it can be a powerful
management tool not so much for providing answers but for highlighting management issues and
for identifying possible alternatives.
4.5 CLASSIFICATION OF RATIOS
Some writers have contended that there are as many as 429 business ratios. But all these ratios
need not be calculated for a particular study. On the basis of the nature of the business concern,
the circumstances in which it is operating, and the particular questions to be answered from the
ratio analysis, certain ratios should only be selected. Every attempt should be made to keep the
number of ratios as far as possible to the minimum. This avoids possible confusion in the
interpretation of ratios.
Financial ratios may be classified in various ways.

I. On the basis of their importance the ratios may be classified as (1) Primary ratios and (2)
Secondary ratios. Operating Profit (before interest and taxes) to operating capital employed
is usually described as the primary ratio. Under this category the various related ratios are
those of operating profit to value of production, cost of production to value of production,
net sales to capital employed etc.
The following ratios are usually included in the secondary ratios category:
The ratios of Direct Materials cost to value of production. Direct Material per factory
employee, out put or work per factory employee, goods for sale per factory employees, etc.
II. On the basis of the source (i.e., the financial statement(s) from which items are taken to
calculate ratios) ratios may be classified into the following categories:
Balance Sheet ratios, or Income Statement ratios and combined ratios.

Balance Sheet ratios are the ratios which express the relationship between items which are
both taken from the Balance Sheet. The current assets to current liabilities (called ‘current
ratio’). Quick assets to current liabilities (called ‘Quick ratio’), Debt-Equity ratio etc. may
be cited as examples.
Income statement ratios are the ratios which deal with the relationship between items of the
Profit and Loss Account. Examples of this ratio are Gross Profit to sales, Net Profit to
Sales, Operating ratio, etc,.
Combined ratios are the ratios which express the relationship between two figures one of
which is drawn from the Balance Sheet and the other from Income Statement.
Its examples are Activity ratios or Turnover ratios, Return on Capital employed, Return on
Shareholders Equity, etc.
III. On the basis of the nature of items the relationships of which are explained by ratios, the
ratios may also be classified as Financial Ratios and Operating Ratios. Financial ratios deal
with non-operational items which are financial in character. Its examples are current ratio,
quick ratio, debt equity ratio, etc.
The operating ratios explain the relationship between items of operations of the firm. Its
examples are turnover or activity ratios, earning ratios, expense ratios, etc.
IV. The most important and commonly adopted classification of ratios is on the basis of the
purpose or function which the ratios are expected to perform. Such ratios are also called
‘functional ratios’. They include solvency ratios, liquidity ratios, activity ratios and
profitability ratios. In fact, the entire ratio analysis can be discussed in relation to the
orientation of the functional basis of ratio classification.
Solvency ratios reveal the long-term solvency of the firm. They show the relative interest
of the owners and creditors in the enterprise.
Liquidity ratios bring out the ability of the firm to honor its financial obligations as and
when they mature.
Activity ratios measure the efficiency with which funds have been employed in the
business operations.
Profitability ratios measure the profit earnings capacity of the enterprise. The profitability
of the firm can be viewed from the point of view of management, owners and creditors.
As mentioned earlier several ratios can be calculated from the data contained in the financial
statements. All these ratios can be grouped into various classes according to the function to be
evaluated. Different persons, as has been pointed out undertake financial statements analysis for
different purposes. For instance, short-term creditors take interest mainly in the short-term
solvency or liquidity position of the firm. Long term creditors are more interested in the long-
term solvency and profitability of the firm and owners’ interest lies in the profitability analysis
and financial condition of the firm. The management of the firm is interested in evaluating every
activity of the firm. In view of the requirements of the various users of financial analysis the
functional classification of ratios becomes important, some important functional ratios are
explained here under:
i) How can you classify the Ratio?

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ii) Give two examples of Balance Sheet ratios.
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4.6 LEVERAGE RATIOS OR CAPITAL STRUCTURE RATIOS
These ratios are also known as ‘long term solvency ratios’ or ‘capital gearing ratios.’ As stated
earlier, the long-term creditors (debenture holders, financial institutions, etc) are more concerned
with the firm’s long-term financial position than with others. They judge the financial soundness
of the firm in terms of its ability to pay interest regularly as well as make repayment of the
principal either in one lump sum or in installments. The long-term solvency of the firm can be
examined with the help of the leverage or capital structure ratios. These ratios indicate the funds
provided by owners and creditors. Generally, there should be an appropriate mix of debt and
owners’ equity in financing the firm’s assets. Each of the two sources of funds, viz., creditors
and owners depending on which of them has been used to finance a firm’s assets, has a number
of implications. Between debt and equity (owners’ funds) debt is more risky from the firm’s
view point. Irrespective of the profits made or losses incurred, the firm has a legal obligation to
pay interest on debt. If the firm fails to pay to debt holders in time, they can take legal action
against the firm to get payment and even can force the firm into liquidation. But at the same time
the use of debt is advantageous to the owners of the firm. They can retain the control of the firm
without dilution and their earnings will be enlarged when the firm earns at a rate higher than the
interest rate on the debt. The owners equity is created as the margin of safety by the creditors. In
view of the above stated facts, it is relevant to assess the long-term solvency of the firm in terms
of the owner’s and creditors contribution to the firm’s total capitalization.
Leverage ratios can be calculated from the Balance Sheet items to determine the proportion of
debt in the total capital of the firm. Though there are many variations of these ratios all of them
indicate the extent to which the firm has used debt in financing its assets.
Leverage ratios are also calculated from the income statements items to determine the extent to
which operating profits are sufficient to cover the fixed charges. This type of leverage ratios are
popularly known as ‘coverage ratios’
The most commonly calculated leverage ratios include: (1) debt equity ratio. (2) debt to total
capital ratio, and (3) gross fixed assets to shareholders funds.
1. Debt-Equity Ratio
This is one of the measures of the long-term solvency of a firm. This reveals the relationship
between borrowed funds and the owners’ capital of a firm. In other words, it measures the
relative claims of creditors and owners against the assets of the firm. This ratio is calculated in
different ways. One way is to calculate the debt equity ratio in terms of the relative proportions
of long-term debt (non-current liabilities) and shareholders’ equity (i.e., common shareholders
equity and preference shareholders equity).
Long term liability
Debt-Equity ratio = Shareholders' equity
Past accumulated losses and deferred expenditure should be excluded from the shareholders
equity. The shareholders equity is also known as the net worth Accordingly, this ratio is also
called debt to net worth ratio.’
Another approach to the calculation of the debt-equity ratio is to divide the total debt (i.e., long
term liabilities plus current liabilities) by the shareholders’ equity.
Total debt
Debt-equity ratio = Shareholders' equity
There is no unanimity of opinion regarding the inclusion of current liabilities in debt for the
purpose of calculating the debt-equity ratio. One opinion is to exclude current liabilities because
of the following aspects:
a) Current liabilities are of short-term nature and the liquidity ratios explain the firm’s
ability to meet these liabilities;
b) The amount of current liabilities widely fluctuates during a year and the interest amount
does not bear any relationship to the book value of current liabilities shown in the
Balance Sheet.
The inclusion of current liabilities in the debt is favoured on the following grounds:
1) Whether long term or short term, liabilities represent the firm’s obligations and so should
be considered in knowing the risk concerning the firm.
2) Like long-term loans short-term loans too have a cost.
3) The pressure from short-term liabilities, in fact, is more on the firm than that of the long-
tem debt.
Interpretation of Debt-Equity ratio
For the analysis of capital structure of a firm debt-equity ratio is important. It shows the extent to
which debt financing has been used in the business. It also shows the relative contributions of the
creditors and the owners of the business to it. A high debt-equity ratio indicates a large share of
financing by the creditors in relation to the owners or a larger claim of the creditors than those of
owners. The D-E ratio indicates the margin of safety to the creditors. A very high D-E ratio is
unfavorable to the firm and introduces an element of inflexibility in the firm’s operations. During
periods of low profits a highly debt financed company will be under great pressure; it cannot
earn enough profits even to pay the interest charges.
A low debt-equity ratio implies a smaller claim of the creditors or a greater claim of the owners.
An ideal D-E ratio is 1:1. However, much will depend on the nature of the enterprise and the
economic conditions in which it is operating. In periods of prosperity and high economic
activity, a large proportion of the debt may be used while the reverse should be done during
periods of adversity.
2. Debt to Total Capital Ratio
This is a variation on the D-E ratio described above. This ratio reveals the relationship between
the outside liabilities and the total capitalization of the firm and not merely the shareholders’
equity. Like the debt-equity ratio, the debt to total capital (or capitalization) ratio takes two
forms:
Long term debt
(a) Debt to Total Capital Ratio = Permanent capital
Permanent capital = Common Shareholders equity + Preference capital + Long term debt
Total Debt
(b) Total Debt to Total Capital Ratio = Permanent Capital+Current liabilites
Interpretation of Debt to Total Capital Ratio
This ratio gives results similar to those of the D-E ratio in respect of the capital structure of a
firm. It indicates the proportion of the outsiders’ funds in the total capitalization of the firm. A
low ratio represents security to creditors while a high ratio represents a risk to creditors. Though
there is no norm prescribed for this ratio, conventionally a ratio of 1:2 is considered to be
satisfactory.
Gross Fixed Assets to Shareholders’ Funds
This ratio indicates the extent to which the shareholders’ funds have been used to finance the
fixed assets. Generally, the owners’ the owners’ capital should be enough to finance the entire
fixed assets and also a part of working capital. The latest thinking or view in this area is that
owners’ capital plus long-term loans should finance the whole of the fixed assets and the core
part of (or fixed) working capital. According to the conservatives, this ratio should generally be
less than one. According to the latest view, the ratio will be more than one. There is not distinct
formula for this purpose. The decision will depend upon the type of business, nature of products
and market acceptability the cost structure, capacity to generate adequate surplus, etc.
Fixed Assets
(Gross) Fixed Assets to shareholders funds (or Net Worth) ratio = Net Worth
Illustration –1
From the following balance sheet calculate the leverage ratios:

Balance Sheet as on 31-12-2000
Birr Birr
Share capital Plant and Machinery 200, 000
Equity share capital 700, 000 (-) Accumulated depn. 500, 000
(70, 000 shares) 400, 000 1,500, 000
8% Preference share capital 400, 000 Goodwill 280, 000
Reserves & Surplus 200, 000 Inventory 300, 000
Long term loan (7%) 500, 000 Receivables 200, 000
8% debentures 120, 000 Prepaid Expenses 50, 000
Creditors 40, 000 Marketable Securities 150, 000
Bills Payable 170, 000 Cash 50, 000
Accrued Expenses 2,530, 000 2530, 000
Solution
Debt-equity ratio: This ratio can be calculated by taking long-term debt or total debt into
account. If the long-term debt alone is considered:
Long term debt
DE Ratio = Shareholders' equity
Birr 200 , 000+500 ,000 700 ,000
=
Birr 700 ,000+400, 000+400 ,000 1 , 500,000 = 0.467: or 46.7%
This indicates a low debt-equity ratio. It suggests that for every one rupee of the owners’ funds
the firm has raised Birr 0.467 of long term debt.
Total debt
If the total debt is considered: the D-E Ratio = Shareholders' equity
Birr 200 ,000+500 , 000+120,000+40 ,000+170 , 000 1, 030, 000
=
= Birr 70 ,000+400 , 000+400 ,000 1, 500, 000 =0.687:1 or 68.7%
Debt to Total Capital Ratio
This ratio can be calculated by taking only the long-term debt or total debt and dividing it by
permanent capital (plus current liabilities).
Long Term debt
(a) Debt to Total Capital Ratio = Total capitalisation or permanent capital
Permanent capital = Equity capital + Preference capital + Reserves and surplus + Long
Term Debt
Birr 200 ,000+500 , 000
Debt to Total Capital Ratio = Birr 700 , 000+400 ,000+200 , 000+500 , 000
700 ,000
= 2,200 ,000 = 0.318:1 or 31.8%
Total Debt
(b) Total Debt to Total Capital Ratio = Permanent capital+Current liabilities
Total debt = Permanent Capital + Current Liabilities
200,000 = 2,200,000 + 330,000
500,000 = 2,530, 000
120,000
40,000
170,000
1,030,000
Birr 1,030,000
= Birr 2,530,000 = 0.407:1 or 40.7%
Fixed Assets
Fixed Assets to Net worth Ratio = Networth or Shareholders' Funds
2,000,000
= 1,500,000 = 1.33:1
In some cases the fixed assets are compared to the total long-term funds, i.e., Net Worth plus
long-term debt in which case the ratio would be
Fixed Assets 2 ,000 , 000
=
Long term funds 2 ,000 , 000 = 1:1
Illustration –2
Given below is the Balance Sheet of a firm as on March 31, 2000

Capital and Liabilities Birr Assets Birr
Equity share capital 200,000 Plant & machinery 302,000
10% preference share capital 80,000 Inventory 121,600
Retained earnings 54,800 Receivables 72,000
Long term debt 68,000 Cash 24,600
Sundry creditors 63,000
Other current liabilities 54,400
520,200 520,200
Calculate the net worth, total debt, total capitalization and permanent capital. Also calculate the
long-term solvency ratios of the firm.
Solution
Net worth = Equity Capital + Preference Capital + Retained Earnings
= 200, 000 + 80, 000 + 54,800 = Birr 334, 800
Total Debt = long term debt + current liabilities
= 68, 000 + 63, 000 + 54, 400 = Birr 185, 400
Total capitalization = Net worth + Total Debt
= Birr 334, 800 + Birr 185, 400
= Birr 520, 200
Permanent capital = Net worth + Long Term Debt
= Birr 334, 800 + Birr 68,000
=Birr 402,800
Leverage Ratios
Long term debt

1. D.E Ratio = Net worth
68,000
= 334,800 = 0.203:1 or 20.3%
Total debt
2. D.E Ratio = Net worth
Birr 185 ,400
= Birr 334 ,800 = 0.554:1 or 55.4%
Birr 68 , 000
3. Long Term Debt to Permanent Capital = Birr 402,800 = 0.169:1 or 16.9%
Birr 185 ,400
4. Total Debt to Total Capital Ratio = Birr 520 ,200 = 0.356:1 or 35.6%
Fixed Assets
5. Fixed Assets to Net worth Ratio = Net worth
Birr 302, 000
= Birr 334, 800 = 0.902:1 or 90.2%
Fixed Assets
6. Fixed Assets to Long Term Funds Ratio = Net worth+ LT Debt
Birr 302,000 Birr 302,000
=
Birr 334 , 800+68,000 Birr 402 ,800 = 0.75:1 or 75%
1. What does Debt-equity ratio reveal?

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2. Give the formula for calculating Debt to total capital ratio.
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4.7 COVERAGE RATIOS
As stated earlier, there are two categories of leverage ratios, viz., Debt-equity ratios and
Coverage ratios. The debt-equity ratios have been explained in the preceding paragraphs. The
second category, i.e., coverage ratios will be explained now.
The debt-equity and debt to total capital ratios indicate whether there is sufficient safety margin
available to the creditors. But normally the assets of the firm will not be sold to satisfy the claims
of the creditors. The claims are usually met out of the regular earnings or operating profits of the
firm. These claims include interest of loans, Preference dividend, repayment of the loan (either in
a lump sum or in installments) and redemption of Preference shares. From the viewpoint of long
term creditors, the financial soundness of the firm lies in its ability to service their claims. This
ability is revealed by the coverage ratios. Thus coverage ratios may be defined as the ratios
which measure the ability of the firm to service fixed interest loans and other Preference
securities.
While D-E ratios are calculated from the Balance Sheet data, the coverage ratios are computed
from items of the Income Statements.
1. Interest Coverage Ratio
This ratio is also known as “times-interest-earned ratio”. This is one of the most conventional
coverage ratios used for knowing the firm’s debt servicing capacity. This ratio is obtained by
dividing earnings (or Net Profit) before interest and taxes (EBIT) by the fixed interest charges on
loans.
EBIT
Interest Coverage = Interest
This ratio shows how many times the interest charges are covered by the EBIT which are
ordinarily available for paying the interest charges. This ratio indicates the extent to which the
earnings of the firm may fall without adversely affecting its debt servicing capacity. A higher
coverage ratio is desirable form the point of view of creditors. But too high a ratio indicates that
the firm is very conservative in using debt. On the other hand, a low coverage ratio indicates
excessive use of debt or inefficient operations.
2. Dividend Coverage Ratio
This ratio measures the ability of a firm to pay dividend on the Preference shares which is
usually a limited percentage. This ratio is expressed in terms of ‘times’, i.e., the profit after tax is
X times the preference dividend.
Profit after tax
Dividend Coverage = Preference dividend
This ratio indicates the safety margin available to the Preference shareholders.
3. Total Coverage Ratio or Fixed Charges Coverage
This ratio has a wider coverage than the earlier two ratios. It takes into account all the fixed
obligations of the firm, viz., interest on loans, preference dividend and repayment of the
principal. This ratio is calculated by dividing the Earnings Before Interest and Taxes (EBIT) by
the total fixed charges.
EBIT
Total Coverage = Total fixed charges
The higher the coverage, the better is the ability of the firm to service debt.
It is difficult to establish a norm for the coverage of fixed charges. Much depends upon the trade
custom and the nature of the business. However, a ratio of 6 to 7% of net profit before tax or 3%
of net profit after tax is taken standard for industrial firms. For utility undertakings the ideal ratio
is 4% of the net profits before tax and 2% of the net profits after tax.
A dividend coverage ratio of at least 2 is expected to act as the standard for reference level.
Illustration –3
From the following particulars calculate the coverage ratios:
Net Profit Birr 300, 000
Income tax Birr 252, 000
Interest Birr 46, 000
Preference dividend Birr 32, 000
Solution
EBIT
Interest Coverage Ratio = Interest
Birr 300 , 000+Birr 252 , 000+Birr 46 , 000 Birr 598 ,000
=
= Birr 46 , 000 Birr 46 ,000 = 13 times
Earnings After Tax
Dividend Coverage = Preference Dividend
Birr 300 ,000
= Birr 32 , 000 = 9.37 times
EBIT
Fixed Coverage = Total Fixed Charg es
Birr 598 , 000 Birr 598 ,000
=
= Birr 46 ,000+Birr 32 ,000 Birr 78 ,000 = 7.67 times
1. What for interest coverage ratio useful?

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2. What does dividend coverage ratio measure?
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4.8 LIQUIDITY RATIOS

Liquidity is the ability of a firm to meet its current or short-term obligations when they become
due. Every firm should maintain adequate liquidity. Liquidity is also known as short-term
solvency of the firm. The short-term creditors of the firm are interested in the short-term
solvency or liquidity of the firm. The liquidity position is better known with the help of cash
budgets and cash flow statements. But liquidity ratios also provide a quick measure of the
liquidity of the firm. The liquidity ratios or short-term solvency ratios establish a relationship
between cash and current assets to current liabilities. A firm’s liquidity should neither be too low
nor too high but should be adequate. Low liquidity implies the firm’s inability to meet its
obligations. This will result in bad credit rating, loss of the creditors’ confidence or even
technical insolvency ultimately resulting in the closure of the firm. A very high liquidity position
is also bad, it means the firm’s current assets are too large in proportion to maturity obligations.
It is obvious that idle assets earn nothing to the firm; and in situations of high liquidity, the
firm’s funds will be unnecessarily tied up in current assets, which, if released, can be used to
generate profits to the firm. Therefore, every firm should strike a balance between liquidity and
lack of liquidity.
The ratios which measure and indicate the extent of liquidity of a firm are known as liquidity
ratios or short-term solvency ratios. They include current ratio, quick ratio or acid test ratio, and
cash position ratio. There is also another measure which is frequently employed to know the
liquidity position of a firm. The measure is the net working capital which represents excess
current assets over current liabilities. The net working capital, strictly, speaking, is not a ratio.
Hence it is not discussed here.
In all the ratios of liquidity, it is the current assets and the current liabilities and the relationship
between them that are analyzed. So it is better to know what the current assets and current
liabilities are and then proceed to study the different liquidity ratios.
Current assets include cash and those assets, which in the normal course of business get
converted into cash within a year or the accounting periods: e.g., cash, marketable-securities,
debtors, stock, etc. Prepaid expenses should also be included in the current assets because they
represent the payments which have been made by the firm for the near future.
Current liabilities are those liabilities or obligations which are to be paid within a year. They
include creditors, bills payable, accrued expenses, bank overdraft, income tax liability and long
term debt maturing in the current year.
1. Current Ratio
Current ratio is the ratio of total current assets to total current liabilities. It is calculated by
dividing current assets by current liabilities.
Current assets
Current ratio = Current liabilities
This ratio is also called ‘working capital ratio’ because it is related to the working capital of the
firm. The current ratio is an important and most commonly used ratio to measure the short-term
financial strength or solvency of the firm. It indicates how many rupees of current assets are
available for one rupee of current liability. The higher the current ratio, the more is the firm’s
ability to meet its current obligations and the greater the safety of the funds of the short-term
creditors. Thus the current ratio, in a way, provides a margin of safety to the (short-term)
creditors.
To the question, “What should be the current ratio of a firm?” there is no clear-cut answer, nor is
there any hard and fast rule for deciding it. Conventionally (The rule of thumb), a current ratio of
2:1 is considered satisfactory. This rule is based on the logic that even in the worst situation
where the value of current assets is reduced by fifty percent, the firm will be able to meet its
current obligations. The standard norm for the current ratio (i.e. 2:1) may vary from firm to firm,
industry to industry or for a firm from time to time. As such, this norm of 2:1 should not be
blindly followed. Also, it should be remembered that this current ratio is a crude measure of
liquidity. It is a quantitative rather than a qualitative index of liquidity. It takes into account the
total value of current assets without making any distinction between the various types of current
assets like receivables, stocks and so on. It does not measure the quality of these assets. If the
firm’s current assets include doubtful and slow paying receivables or slow moving and non-
moving (non-saleable) stock of goods, then the firm’s ability to meet obligations would be
reduced. This aspect is ignored by the current ratio. That is why too much reliance should not be
placed on the current ratio. The ability of the assets also should be ascertained.
Illustration –4
The assets and liabilities of a firm as on the 31 st of Dec., 2000 were as under. Calculate the
current ratio and its net working capital.
Assets Birr Liabilities & Capital Birr

Plant 4, 000, 000 Share Capital 3, 000, 000
Buildings 2, 000, 000 Reserves & Surplus 800, 000
Stock 1, 500, 000 Debentures 3, 000, 000
Receivables 1, 000, 000 Creditors 600, 000
Prepaid Expenses 250, 000 Bills Payable 200, 000
Marketable Securities 750, 000 Accrued Expenses 200, 000
Cash 2, 500 Provision for Taxation 650, 000
Long Term Loan 1, 300, 000
Solution
For calculating the current ratio we need to know the current assets and current liabilities
Current Assets Birr Current Liabilities Birr
Cash 250, 000 Creditors 600, 000
Mkt. Securities 750, 000 Bills Payable 200, 000
Debtors 1, 000, 000 Accrued Expenses 200, 000
Stock 1, 500, 000 Provision for Taxation 650, 000
Prepaid Expenses 250, 000 _________
_________
3, 750, 000 1, 650, 000
Current assets
Current Ratio = Current liabilities = 2.75:1
Net working capital = Current Assets – Current Liabilities
= Birr 3, 750, 000 – Birr 1, 650, 000 = Birr 2, 100, 000
2. Quick Ratio or Acid Test Ratio
This ratio measures the relationship between Quick assets (or liquid assets) and current
liabilities. An asset is considered liquid if it can be converted into cash without loss of time or
value. Cash is the most liquid asset. Other assets which are considered to be relatively liquid and
include in the quick assets are accounts receivable (i.e. debtors and bills receivable) and short
term investments in securities. Stock or inventory is excluded because it is not easily and readily
convertible into cash. Similarly, prepaid expenses, which cannot be converted into cash and be
available to pay off current liabilities, should also be excluded form liquid assets.
The quick ratio is calculated by dividing quick assets by current liabilities:

Quick assets
Quick Ratio = Current liabilities
Quick ratio is a more refined and vigorous measure of the firm’s liquidity. It is widely accepted
as the best test for the liquidity of a firm.
Generally, a quick ratio of 1:1 is considered to be satisfactory. But this ratio also should be used
cautiously. It should also be subjected to qualitative tests, i.e., quality of the assets included
should be assessed.
Illustration –5
Taking the same particulars of assets and liabilities given in illustration –4 of the unit, calculate
the quick ratio.
Solution
Quick Assets Birr Current Liabilities Birr
Cash 250, 000 Current Liabilities 1, 650, 000
Securities 750, 000
Debtors 1, 000, 000
2, 000, 000
Quick assets Birr 2, 000 , 000
=
Quick Ratio = Current liabilities Birr 1, 650 , 000 = 1.21:1
3. Cash Position Ratio
This is also known as ‘super quick ratio’ or ‘super acid test ratio’. It is a still more rigorous test
of liquidity. For calculating this ratio, from the total quick assets the accounts recoverable
(debtors and bills receivable) will also be excluded.
Cash+Short Term Investments
Cash Position Ratio = Current Liabilities
The standard norm for this ratio, too, is 1:1.
This ratio is a conservative test of liquidity and is not widely used in practice.
By taking the particulars of assets and liabilities given in Illustration –1, the cash position ratio of
the firm can be calculated thus:
Cash+Securities
Cash Position Ratio = Current Liabilities
Birr 1,000,000
= Birr 1,650,000 = 0.61: 1
1. Give two examples of liquidity ratios.

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2. Name three current assets.
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3. List out three current liabilities.
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4. How is current ratio calculated?
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5. What does quick ratio measure?
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4.9 ACTIVITY RATIOS
The finances obtained by a firm from its owners and creditors will be invested in assets. These
assets are used by the firm to generate sales and profits. The amount of sales generated and the
obtaining of the profits depend on the efficient management of these assets by the firm. Activity
ratios indicate the efficiency with which the firm manages and used its assets. That is why these
activity ratios are also known as ‘efficiency ratios’. They are also called ‘turnover ratios’ because
they indicate the speed with which assets are being converted or turned over into sales. Thus the
activity or turnover ratio measures the relationship between sales on one side and various assets
on the other. The underlying assumption here is that there exists an appropriate balance between
sales and different assets. A proper balance between sales and different assets generally indicates
the efficient management and use of the assets. Many activity ratios can be calculated to know
the efficiency of asset utilization. The following are some of the important activity ratios or
turnover ratios:
1. Total Assets Turnover Ratio
This ratio measures the overall performance and efficiency of the business enterprise. It points
out the extent of efficiency in the use of assets by the firm. This ratio is calculated by dividing
the annual sales value by the value of total assets. Normally, the value of sales should be
considered to be twice that of the assets. A lower ratio than this indicates that the assets are lying
idle while a higher ratio may mean that there is overtrading. Sometimes, intangible assets
(goodwill, patents, etc) are excluded from the total assets and the total tangible assets-turnover
ratio is calculated. For calculating this ratio fictitious assets (P & L A/c debit balance, deferred
expenditure, etc) should be ignored.
2. Capital Employed Turnover
This is also known as ‘Sales-Net worth Ratio’. The capital employed is equal to the non-current
liabilities plus the owners’ equity. This represents the permanent capital or long term funds
entrusted to the firm for use by the owners and creditors. The capital employed can be treated as
equivalent to the net working capital plus the non-current assets. This ratio examines the
effectiveness in utilizing the capital employed. It is calculated by dividing the sales value by the
capital employed.
Thus the ratio indicates the firm’s ability to generate sales per rupee of the capital employed
(long term funds). The higher the ratio, the more efficient the utilization of the owners’ and the
long term creditors’ funds are. This ratio of a firm should be compared with the industry average
or similar ones.
If the Sales-Net worth ratio of a firm is found to be excessively large in comparison to that of
similar firms or the industry average, it is said to be a case of overtrading, i.e., the handling of a
larger turnover than is warranted by its net worth.
The efficiency of the operations of a firm need not be ascertained solely on the basis of this ratio.
Other ratios which are related to it also should be considered.
3. Fixed Assets – Turnover Ratio
This ratio measures the firm’s efficiency in utilizing its fixed assets. Firms which have large
investments in fixed assets usually consider this ratio important. It indicates the extent of
capacity utilization in the firm. The ratio is calculated by dividing the total value of sales by the
amount of fixed assets invested. A high ratio is an indicator of overtrading while a low ratio
suggests idle capacity or excessive investment in fixed assets. Normally, a ratio of five times is
taken as a standard.
Some analysts suggest the exclusion on intangible assets like goodwill, patents, etc., for
calculating this ratio. For calculating this ratio, the gross fixed assets figure is preferred to the net
value figure.
4. Current Assets Turnover
This ratio is calculated by dividing the net sales value by that of the current assets. It indicates
the contribution of current assets to the sales.
5. Working Capital Turnover
This ratio indicates the efficiency of the employment of working capital. If supplemented with
the net worth turnover ratio, it indicates the under capitalization of the overtrading of the
concern. A firm is said to be undercapitalized if its return on capital is unusually high when
compared to similarly situated firms. This ratio is calculated by dividing the net sales value by
the net working capita. There is no standard norm for this ratio. It can only be stated that the firm
should have adequate and appropriate working capital to justify the sales generated.
6. Stock Turnover or Inventory Turnover
This ratio indicates the efficiency of the firm’s inventory management. It is calculated by
dividing the cost of goods sold by the average inventory.
Cost of goods sold
Stock Turnover = Average stock
Cost of goods sold = Sales – Gross Profit or
Opening Stock + Purchases + Mfg. Costs – Closing Stock.
Average Stock = (Opening Stock + Closing Stock) ¿ 2.
If the particulars of cost of goods sold and average stock are not available in the published
financial statements the stock turnover can be calculated by dividing sales by the stock at the
end, i.e.,
Sales
Inventory Turnover = Closing Stocks
Between the two formulae given above for calculating the stock turnover the former is more
logical and more appropriate than the latter.
This ratio indicates the rapidity with which the stock is turning into receivables through sales.
Generally, a high inventory turnover is an index of good inventory management and a low
inventory turnover indicates an inefficient inventory management. Low stock turnover implies
the maintenance of excessive stocks which are not warranted by production and sales activities.
It also may be taken as an indication of slow moving or non-moving and obsolete inventory. A
too high inventory turnover also is not good. It may be the result of a very low level of stocks
which may result in frequent stock-outs. The stock turnover should be neither too high nor too
low.
Illustration –6
The sales of a firm amounted to Birr 600, 000 in a particular period on which it had a gross
margin of 20%. The stock at the beginning of the period was worth Birr 70, 000 and at the end of
the period of Birr 90, 000. Calculate the inventory turnover ratio.
Solution
Cost of goods sold
Inventory turnover = Average inventory
Birr 600 , 000−120 , 000 Birr 480 , 000
= =6 times
= (Birr 70 , 000+Birr 90 , 000)÷2 Birr 80 , 000
7. Debtors Turnover
Credit sales are not an uncommon feature. When the firm sells goods on credit, book debts
(receivables) are created. Debtors are expected to be converted into cash over a short period and
hence are included in current assets. To a great extent the quality of debtors determines the
liquidity position of the firm. The quality of debtors can be judged on the basis of debtors
turnover and average collection period.
Receivable turnover is calculated by dividing credit sales by average receivables

Credit sales
Receivables turnover = Average receivables
This ratio indicates the number of times on an average the debtors or receivables turnover each
ear are created. The higher the value of debtors turnover, the more efficient is the management of
assets.
If the information about credit sales opening and closing balances of receivables is not available
in the financial statements, the receivables turnover can be calculated by taking the total sales
and closing balance of receivables
Total sales
Debtors turnover = Re ceivables
Illustration –7
The total sales of a firm amounted to Birr 600, 000 during a year out of which the cash sales
amounted to Birr 200, 000. The outstanding amounts of debt at the beginning and at the end of
the year were Birr 30, 000 and Birr 40, 000 respectively. Calculate the receivables turnover ratio.
Solution
Credit sales
Receivables Turnover = Average debtors
Birr 400 , 000 Birr 400 , 000
=
= (Birr 30 , 000+Birr 40 , 000)÷2 Birr 35 , 000 = 11.4 times
8. Average Collection Period
As stated earlier the average collection period ratio is another device for indicating the quality of
receivables. This ratio shows the nature of the firm’s credit policy also. The average collection
period is calculated by dividing days (or months) in a year by the receivables’ turnover.
Days in a year/12 months
Average Collection Period = Re ceivables' Turnover
The average collection period and the receivables’ turnover are interrelated. The receivables
turnover can be calculated by dividing days in the yare by the average collection period.
The average collection period indicates the rigidity or slowness of their collectibility. The shorter
the period, the better the quality of debtors, since the shorter collection period implies prompt
payment by debtors. The firm’s average collection period should be compared with the firm’s
credit terms and policy to judge its credit and collection policy. An excessively long collection
period implies a too liberal and inefficient credit and collection performance while a too low
period indicates a very restrictive or strict credit and collection policy. The firm’s average
collection period should be reasonable and not totally different from that of the industry’s
average.
Taking the particulars of Illustration –7, the average collection periods may be calculated thus:
365
Average Collection Period = 11.4 = 32 days.
1. What is Total Assets Turnover Ratio?

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4.10 PROFITABILITY RATIOS
Every firm should earn adequate profits in order to survive in the immediate present and grow
over a long period of time. In fact, the profit is what makes the business firm run. It is described
as the magic eye that mirrors all aspects of the business operations of the firm. Profit is also
stated as the primary and final objective of a business enterprise. It is also an indicator of the
firm’s efficiency of operations. There are different persons interested in knowing the profits of
the firm. The management of the firm regards profits as an indication of efficiency and as a
measure of control. Owners take it as a measure of the worth of their investment in the business.
To the creditors profits are a measure of the margin of safety. Employees look at profits as a
source of fringe benefits. To the government they act as a measure of the firm’s tax paying
ability and a basis for legislative action. To the customers they are a hint for demanding price
cuts. To the firm they constitute a less cumbersome and low cost source of finance for existence
and growth. Finally, to the country profits are an index of the economic progress, the national
income generated and the rise in the standard of living of the people. Therefore, every firm
should earn sufficient profits in order to discharge its obligations to the various persons
concerned.
Profitability means the ability to make profits. Profitability ratios are calculated to measure the
profitability of the firm and its operating efficiency. They relate profits earned by a firm to
different parameters like sales, capital employed, and net worth. But while making financial ratio
analysis relating to profits, it should be noted that there are different concepts of profits such as
contribution (sales revenue minus variable costs), gross profit, profit before tax, profit after tax,
profit before interest and taxes, operating profit, profit has to be used for making the profitability
analysis suitable for analyzing specific problems. Profitability ratios can be calculated with
reference to the different concepts of profit mentioned earlier.
Profitability of the firm can be measured by calculating several interrelated ratios demanded by
the aims of the analyst. The profitability of a firm can be measured and analyzed from the point
of view of management, owners (i.e., shareholders in the case of companies) and creditors.
From the management point of view, profitability ratios are calculated for measuring the
efficiency of operations. There are two types of profitability ratios calculated for this purpose.
They are:
I. Profitability in relation to sales, and
II. Profitability in relation to investment.
Every firm should generate sufficient profit on each Birr of sales otherwise it would be very
difficult for the firm to recover operating expenses and non-operating expenses like interest
charges. Similarly, if the firm’s earnings are not adequate in term’s of its investment in assets
and in terms of capital employed (contributions by owners and creditors) its very survival will be
at stake.
I. Profitability in relation to sales
Under this category many profitability ratios are calculated relating different concepts of profit to
the sales value. Some such ratios are:
1. Gross Profit margin or Gross Profit to Sales
This ratio is calculated by dividing gross profit by sales value.

Gross profit Sales−Cost of goods sold
=
Gross profit margin = Sales Sales
This ratio is usually expressed as a percentage. It indicates the efficiency with which
management produces each unit of product or service. It reveals the spread (difference) between
sales value and cost of goods sold. A high gross profit margin (compared to the industry average)
indicates relating lower cost of production of the firm concerned. It is an index of good
management. A lower gross margin indicates higher cost of goods sold (which might be due to
purchase of an unfavorable items inefficient utilization of plant and machinery or over-
investment in plant, machinery and equipment), or lower sales values (which could be due to fall
in prices in the market, reduction in selling price, less volume of sales, etc.)
2. Gross Operating Margin
This ratio is calculated by dividing gross operating margin by sales.
Gross operating margin = Gross profit minus operating expenses except depreciation.
This ratio indicates the extent to which the selling price per unit may decline without incurring
any loss in the business operations. It is rather difficult to evolve a standard norm for this ratio.
But it should not be lower than that of similar concerns.
Example: Sales: Birr 1, 000, 000; Gross profit: Birr 500, 000; Operating expenses excluding
depreciation: Birr 100, 000; Depreciation: Birr 10, 000.
Birr 500 ,000−Birr 100 ,000
Gross operating margin = Birr 1,000 , 000 = 40%
3. Net Operating Margin
This ratio is calculated by dividing the net operating profit by (net) sales. The net operating profit
is obtained by deducting depreciation form the gross operating profit. Taking the particulars of
the example given above, the net operating margin may be calculated as follows:
Gross Operating Margin−Depreciation×100
Net Operating Margin = Sales
Birr 400 ,000−Birr 10, 000
= Birr 1, 000, 000 = 39%
For this ratio no standard norm is evolved. The ratio of a firm may be compared with that of
sister concerns to measure the relative position.
4. Net Profit Margins or Net Profit to Sales
This is one of the very important ratios and measures the profitableness of sales. It is calculated
by dividing the net profit by sales. The Net profit is obtained by subtracting operating expenses
and income tax from the gross profit. Generally, non-operating incomes and expenses are
excluded for calculating this ratio. This ratio measures the ability of the firm to turn each Birr of
sales into net profit. It also indicates the firm’s capacity to withstand adverse economic
conditions. A high net profit margin is a welcome feature to a firm and it enables the firm to
accelerate its profit at a faster rate than a firm with a low net profit margin.
In order to have a more meaningful interpretation of the profitability of a firm, both gross margin
and net margin should jointly be evaluated. If the gross margin has been on the increase without
a corresponding increase in net margin, it indicates that the operating expenses relating to sales
have been increasing. The analyst should further analyze in order to find out the expenses which
are increasing. The net profit margin can remain constant or increase with a fall in gross margin
only if the operating expenses decrease sufficiently.
5. Operating Ratio
The ratio is an index of the operating efficiency of the firm. It explains the changes in the net
profit margin. This ratio is calculated by dividing all operating expenses (i.e., cost of goods sold
plus administration and selling expenses) by sales.
Cost of goods sold+Operating expenses
Operating ratio = Sales
This ratio is also expressed as a percentage.
A higher operating ratio is always unfavorable because it would leave only a small amount of
operating income for meeting non-operating expenses (like interest) dividends, etc. In other to
get an idea about the operating efficiency of the firm, this ratio over a number of years should be
studied. Variations on the operating ratio occur because of many factors such as changes in
operating expenses and cost of goods sold, changes in sale price or demand for the product and
volume of sales. Thus there are both internal and external (and uncontrollable) factors which
influence the operating ratio of a firm. As such, this ratio should be used cautiously. This ratio
again cannot be of much use to firms where the non-operating incomes and expenses constitute a
significant part of the total income.
Example
Sales: Birr 2, 000, 000; Opening Stock: Birr 200, 000; Manufacturing cost: Birr 1, 000, 000;
Closing Stock: Birr 150, 000; Administrative Expenses: Birr 50, 000; Selling Expenses: Birr
40,000; Depreciation: Birr 40, 000. Calculate the operating ratio.
Solution
Cost of goods sold+Operating expenses
Operating Ratio = Sales
(Birr 200 ,000+1 , 000 ,000−Birr 150 ,000 )+( Birr 50 , 000+Birr 40 ,000+Birr 40, 000 )
=
Birr 2,000 ,000
Birr 1,050 ,000+Birr 130 ,000 Birr 1,180 ,000
= = =0.59 or 59 %
Birr 2,000 ,000 Birr 2 ,000 ,000
Expense Ratios
The operating ratio gives an aggregate picture of the operating efficiency of the firm. To know
how individual expense items behave, the ratio of each individual operating expense to sales
should be calculated. These ratios, when studied over a period of years, help in knowing the
managerial efficiency in the fields of operations concerned. Taking the particulars of the example
given for operating ratio, calculation of different ratios can be as follows:
Birr 1,050,000
Cost of goods sold to Sales = Birr 2,000,000 = 52.5%
Birr 50,000
Administrative expenses to Sales = Birr 2,000,000 = 2.5%
Birr 40,000
Selling Expenses to Sales = Birr 2,000 ,000 = 2.00%
Birr 40,000
Depreciation to Sales = Birr 2,000,000 2.00%
Illustration –8
Calculate the profitability ratios relating to sales from the following Income Statement of
S.S.PLC.
Income Statement for the year ending on …
Sales 2, 000, 000

(-) Cost of Goods 1, 400, 000
Gross Profit 600,000
(-) Operating Expenses:
Office 50, 000
Selling & Distribution 20, 000
70, 000
Gross Operating Margin 530, 000
(-) Depreciation 130, 000
Net Operating Profit 400, 000
+ Non-operating income 10, 000
(-) Non-operating exp. Int. 20, 000
10, 000
Net Profit before tax 390, 000
(-) Income Tax (50%) 195,000
Profit After Tax 195,000
Solution
Gross Profit Birr 600 ,000
×100= ×100=30 %
Gross Profit Margin = Sales Birr 200 ,000
Gross Operating Profit Birr 530 , 000
= ×100=26 . 5%
Gross Operating Margin = Sales Birr 2, 000 , 000
Net Operating Profit Birr 400 ,000
= =20 %
Net Operating Profit = Sales Birr 2 ,000 ,000
Net Profit After Tax Birr 195 , 000
= =9 . 75 %
Net Profit Margin = Sales Birr 2, 000 , 000
Cost of goods sold+Operation Expenses
Birr 1, 400 ,000+Birr 50 ,000+Birr 20, 000+Birr 130 , 000
=
Birr 2,000 ,000
Birr 1, 600 ,000
= =80%
Birr 2,000 ,000
Birr 1, 400 ,000
=70%
Cost of goods sold to Sales = Birr 2, 000 ,000
Birr 50,000
=2.5%
Office Expenses to Sales = Birr 2,000,000
Br. 20,000
1.00%
Selling and distribution expenses to Sales = Br. 2,000,000
Br. 130,000
=6.5%
Depreciation to Sales = Br. 2,000,000
Profitability of a firm in relation to sales can also be analyzed by calculating the activity of
turnover ratios which have already been explained in the earlier unit.
II. Profitability in Relation to Investment
Profitability of a firm can also be measured in terms of the investment made. The term,
‘investment’, may refer to total assets, total operation assets, capital employed or the owners’
equity. Accordingly, many profitability ratios in relation to investment can be calculated. The
important ratios in relation to investment can be calculated. The important ratios are discussed
here under:
1. Return on assets
This ratio is calculated by dividing net profit after tax by total assets:
Net Profit After Tax
Return On Assets (ROA) = Total Assets
There are many variations on the return on assets ratio mix depending on the particular concept
of net profit and assets used. The different concepts of net profit used include net profit after tax,
net profit after tax plus interest (on loans), net operating profit, and net profit after taxes plus
interests minus tax savings.
Similarly, the concept ‘assets’ may indicate total assets, fixed assets, tangible assets, operating
assets, etc.
The different variants of the Return on Assets may be as under:

Return on Assets = Total Assets
Net Profit After Tax+Interest
= Total Assets
= Tangible Assets
= Fixed Assets
Operating Profit
= Operating Asstes
Operating assets are the assets which are used in the regular conduct of the business operations.
They include mostly tangible fixed assets and current assets. Investments are generally excluded
when calculating the operating assets.
This Return on Assets ratio measures the profitability of the total assets (or investment) of a firm.
But this ratio does not throw any light on the profitability of the different sources of funds which
have financed the total assets. This aspect of profitability is covered by Return on capital
employed.
2. Return on Capital Employed
This is a similar to ROA except that in this ratio profits are related to the capital employed. The
term, ‘capital’, employed refers to the long-term funds supplied by creditors and owners of the
firm. This ratio indicates how efficiently the management of the firm has used the funds supplied
by creditors and owners. The Capital employed can be ascertained in two ways by taking the
non-current liabilities plus owners’ equity or by considering the net working capital plus net
fixed assets. The higher the ratio ROCE, the more efficient has been the use of capital (long term
funds) employed.
The Return on capital employed can be calculated by using different concepts of profit and
capital employed.
ROCE = Total Capital Employed
or
= Total Capital Employed
= Total Capital Employed−In tan gible Assets
Illustration –9
From the following particulars calculate the profitability ratios in terms of investment:
Balance Sheet as on …
Birr Birrs
Plant & Machinery 1, 200, 000 Equity Share Capital
Goodwill 150, 000 (50, 000 shares) 500, 000
Current Assets 350, 000 8% Preference Capital 300, 000
Reserves & Surplus 200, 000
8% Long-term Loans 200, 000
8% Debentures 300, 000
Current Liabilities 200, 000
1,700, 000 1, 700, 000
Net profit after tax: Birr 200, 000; interest: Birr 40, 000
Solution
Capital employed = Non-current Assets + Net Working Capital

= 1, 350, 000 + (350, 000 – 200, 000) = Birr 1, 500, 000
or
Long Term Funds + Owners’ Equity
= Birr 500, 000 + Birr 1, 000, 000 = Birr 1, 500, 000
Profit After Tax Br . 200 ,000
=
ROCE = Capital Employed Br. 1,500 ,000 13.35%
Profit After Tax+Interest
ROCE = Capital Employed
Br . 200 ,000+Br . 40 ,000 Br . 240 ,000
=
= Br. 1,500 ,000 Br. 1,500 ,000 = 16%
Profit After Tax+Interest
ROCE= Capital Employed−Intangible assets
Br . 240 , 000 Br . 240 ,000
= =17 .78 %
= Br . 1,500 ,000−Br . 150 , 000 ( goodwill) Br . 1,350 , 000
The Profitability of the firm can be judged from the owners’ point of view also. In the case of the
company’s shareholders the ordinary or common shareholders specially represent ownership.
While analysis the profitability, the shareholders are interested in the net profits accruing to
them, the dividend policy of the firm, earnings per share, growth in the earnings, impact of
earnings on the market price of shares, etc. They also conduct certain market tests of
profitability. Some important ratios of profitability form the shareholders’ point of view are
presented here.
3. Return on Shareholders’ Equity
The shareholders of a company may comprise equity shareholders and Preference shareholders.
Preference shareholders are the shareholders who have a priority in receiving dividends (and in
the return of capital at the time of winding up of the company). The rate of dividend on the
preference shares is fixed. But the ordinary or common shareholders are the residual claimants of
the profits and ultimate beneficiaries of the company. The rate of dividend on these shares is not
fixed. When the company earns profits it may distribute all or a part of the profits as dividends to
the equity shareholders or retain them in the business itself. But the profits after taxes and after
Preference Shares dividend payment presents the return as equity of the shareholders.
A return on shareholders’ equity is calculated to assess the profitability of the owners’

investment. The shareholders’ equity is ascertained by adding up equity Share capital, Preference
share capital, share premium, reserves and surplus. If any accumulated losses are there, they
should be deducted from this amount. The shareholder’s equity is also called net worth.
Return on shareholders’ equity or return on net worth is calculated by dividing the net profit after
tax by the total shareholders’ equity or net worth.
Net Profit After Taxes
Return on shareholders’ equity = Shareholders' Equity
Example:
Taking the particulars given in Illustration 9, the shareholders’ equity and return on it are
calculated here:
Shareholders’ equity = Equity share capital + Pref. Share Capital + Res. & Surplus
= Br. 500, 000 + Br. 300, 000 + Br. 200, 000
+ Br. 1, 000, 000
Br.200 ,000
=20 %
Return on shareholders’ equity = Br .1,000 ,000
This ratio reveals how profitability owners’ funds have been utilized by the firm. A comparison
of this ratio with that of similar firms and with the industry average reveals the relative financial
soundness and performance of the firm.
4. Return on Equity Shareholders’ Funds
The real shareholders of a company are its equity shareholders who are the ultimate owners.
They are entitled to all the profits remaining after all outside claims are met and preference
dividend paid. In view of this, the profitability of a firm should be assessed in terms of return to
the equity shareholders. It is calculated by dividing profits after taxes and preference dividend by
the equity.
Profit After Tax - Pref . Dividend
Return on equity shareholders funds = Equity Shareholders' Equity
Equity shareholders’ equity is total shareholders’ equity minus Preference shareholders’ equity.
It can also be calculated as ordinary paid up share capital plus share premium plus reserves and
surplus less accumulation losses.
Example: Taking the particulars of Illustration –9 equity shareholders’ funds will be as under:
Return on equity shareholders equity = Equity Sh. Cap.+Re serves∧Surplus
Br . 200 ,000−Br . 24 , 000 Br . 176 , 000
= =25 .14 %
= Br . 500 , 000+Br . 200 ,000 Br . 700 , 000
5. Earnings Per Share (EPS)
EPS is another measure of profitability of a firm from the point of view of the ordinary
shareholders. It reveals the profit available to each ordinary share. It is calculated by dividing the
profit available to ordinary shareholders, (i.e., profit after tax minus Preference dividend) by the
number of outstanding equity shares.
EPS = No . of Equity Share Outs tan ding
The EPS of the firm the particulars of which are given in Illustration –9 is calculated as under:
Br . 176,000
=Br .3.52
EPS = 50 ,000
The EPS of a firm studied over years indicates whether or not the earnings per share basis has
changed over the period. To assess the relative profitability of the firm its EPS should be
compared with that of similar concerns and the industry average.
EPS is a widely used ratio, specially for analyzing the effect of a change in leverage on the net
operating earnings to the equity shareholders. This analysis is of immense value in evolving an
appropriate capital structure for a firm.
6. Dividend Per Share (DPS)
The net profits after taxes and Preference dividend belong to the equity shareholders and EPS
reveals how much of it is it per share. But no company is under the obligation to distribute all the
profits as dividends to the shareholders. In pursuance of the policy which the company has
evolved it may retain all or some profits and distribute the balance as dividends. A large number
of potential or prospective investors are interested in knowing the dividends which the company
distributes per share. The Dividend Per Share (DPS) is calculated by dividing the profits
distributed as dividend by the number of equity share outstanding.
Earnings distributed as dividend to equity shareholders

D.P.S. = No . of equity shares outstanding
Example:
Example: If the company (the particulars of which are given in Illustration –9) is assumed to
have distributed Br. 150, 000 as dividends.
Br .150 , 000
=Br . 3/−
DPS = 50, 000
7. Dividend Payment Ratio
This is calculated by dividing the DPS by the EPS or by dividing the total dividends paid by total
earnings made.
DPS
Dividend Payment Ratio = EPS
This shows the percentage of profit after taxes and Preference dividend distributed as dividends.
If the DPR ratio is subtracted from 100, it will give the retention ratio, i.e., percentage of profits
retained in the business.
8. Dividend Yield
The dividend yield is the DPS divided by the market price per share. This indicates the
shareholder’s return (dividend) in relation to the market value per share.
Dividend per share
Dividend yield = Market price per share
9. Earnings yield
The earnings yield is the EPS divided by the market price per share. It is also known as Earnings
Price Ratio.
Earnings per share
Earnings yield = Market price per share
10. Price Earnings ratio
This is reciprocal of earnings yield. This ratio is widely used by security analysts to evaluate the
firm’s performance and what is expected by the investors.
Market value per share
PE Ratio = EPS
This indicates the investor’s expectations in respect of the firm’s performance.
The profitability of a firm can be assessed form the point of view of creditors also. The suppliers
of funds, i.e., the creditors are interested in the profits as they constitute the sources from which
regular payment of interest and repayment of loan (in a lump sum or in installments) will be
made. They measure the profitability for the interest and fixed charges and also debt servicing.
11. Earning Power
This is an indicator of the overall profitability of the firm. In the earlier paragraphs the measures
of (i) profitability from the point of view of owners and (ii) operating efficiency of the firm have
been explained. Individually, these two types of ratios do not provide a complete picture of the
effectiveness of the firm and its overall profitability. A high profit margin no doubt is an index of
better operational performance but a low margin does not necessarily imply a low rate of return
on investment if the firm has a higher investment turnover. Therefore, the overall profitability
and operating efficiency of the firm can be assessed on the basis of a combination of the two
ratios. The combined profitability measures which has a combination of net profit margin and the
investment turnover is known as earning power or return on investment ratio (ROI). The
earnings power of a firm may be defined as the overall profitability of the concern. This earning
power has two elements, viz., net profit margin which is a measure of profitability on sales and
investment turnover which reveals the profitability of investments. Thus the earning power of a
firm is the product of net profit margin and the investment turnover. That is,
Earning Power = Return on investment

Net Profit After Tax Sales
×
= Sales Cap . employed or total assets
= Capital Employed or Total Assets
Du Point Chart
As stated above, the earning power of a firm is represented by the return on capital employed. It
shows the combined effect of the net profit margin and the investment turnover. A change in any
of these ratios will affect the firm’s earning power. But these two ratios in turn are affected by
many factors. Thus the factors affecting the earning power may be presented in the form of a
chart. This chart is called ‘Du Chart’ because it was first used by the Du Point Company of the
U.S.A.
Earning Power
Return on Investment
Multiplied by
Profit Margin Investment Turnover
Net Profit Divided by Sales Sales Divided by Investment
Sales minus Expenses Non-current Plus Working

assets capital
Cost of Goods Sold

plus
Operating Expenses
plus
Other Expenses
minus
Income Tax
Du point chart
1. How is Gross profit margin calculated?

………………………………………………………………………………………………
………………………………………………………………………………………………
……………………………………………………………………………………..
2. What is operating ratio?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………
3. What do you understand by Earnings Per Share (EPS)?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………
4. How is price earnings ratio calculated?

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………
4.11 SUMMING UP
Ratio analysis is the most useful and widely used tool of financial analysis. A purposeful ratio
analysis helps in identifying problems such as whether the financial condition of the firm is
sound; whether capital structure of the firm is appropriate; whether profitability of the enterprise
satisfactory; whether the credit policy of the firm is sound etc.
However, ratio analysis suffers from certain limitations. Ratios themselves are not of much
significance. They become useful only when they are compared with some standards. Ratio
analysis is likely to give misleading result if the effect of changes in price level are not taken into
account. Ratio analysis is not meaningful unless the questions sought to be answered are clearly
formulated. The nature of the business characteristics which affect the figures in the financial
statement and their inter-relationship should be clearly understood and born in mind in order to
make a meaningful ratio analysis.
Ratios may be classified on the basis of their importance as primary ratios and secondary ratio;
on the basis of sources as balance sheet ratios and income statement ratios; on the basis of nature
of items as financial ratios and operating ratios and on the basis of the purpose as solvency ratios,
liquidity ratios, activity ratios and profitability ratios.
Several ratios can be calculated from the data contained in the financial statements. Different
persons undertake financial statement analysis for different purposes. For instance, short-term
creditors show interest mainly in the short-term liquidity position of the firm. Owner’s interest
lies in the profitability analysis and financial condition of the firm. The management of the firm
is interested in evaluating every activity of the firm. Ratio analysis meets the requirements of all
the above persons.
The leverage or capital structure ratios help to understand the long term solvency of the firm
while liquidity ratios are useful to measure the short-term solvency of the firm. Activity ratios
indicate the efficiency with which the firm manages and uses its assets. Hence they are also
called as efficiency ratios. Profitability ratios, on the other hand, are useful to measure the
profitability of the firm and its operating efficiency.
4.12 ANSWERS TO CHECK YOUR PROGRESS
1. i) Ratios can be classified:

1. On the basis of importance
2. On the basis of source
3. on the basis of nature of items
4. On the basis of purpose or function
ii) 1. Current ratio (current assets to current liabilities)
2. Debt-equity ratio.
2. i) Debt-equity ratio reveals the relationship between borrowed funds and owners’ capital
of a firm.
Long Term Debt
ii) Debt to total capital = Permanent Capital+Current
3. i) It is useful for knowing the firm’s debt servicing capacity.
ii) Dividend coverage ratio measures the ability of a firm to pay dividend on preference
shares.
4. i) a) Current ratio b) Quick ratio
ii) a) Cash b) Debtors c) Stock
iii) a) Creditors b) Bills payable c) Bank overdraft
Current Assets
iv) Current Ratio = Current Liabilities
5. Total assets turnover ratio is calculated by dividing the annual sales value by the value of
total assets.
Gross Profit
6. i) Gross profit margin = Sales
ii) Operating ratio explains the changes in net profit margin.
Cost of goods sold+Operating Expenses

iii) Earnings per share reveals the profit available to each ordinary share.
Profit After Tax−Preference Dividend
EPS = No. of equity shares outstanding
Market value per share
iv) P.E. Ratio = EPS
4.13 MODEL EXAMINATION QUESTIONS
A. Answer the following questions in about 15 lines.

1. What is a ratio?
2. Explain the meaning of ratio analysis.
3. How is ratio analysis useful?
4. State the important limitations of ratio analysis.
5. What are leverage ratios?
6. What is Acid-Test Ratio?
7. How is Return on investment calculated?
8. Explain the following:
a) Net worth b) Operating Ratio
c) E.P.S. d) Current ratio
9. What do you understand by debt-equity ratio?
10. How can you classify the ratios on the basis of purpose or function?
4.14 RECOMMENDED BOOKS
 Kuchhal S.C. : Financial management, Chaitany Publishing House Allahabad.

 Pandey IM. : Financial management, Vikas Publishing House Put Ltd.
New Delhi.
 Brigham EF : Fundamentals of Financial Management Dryden Press, Chicago
 Gitman L.J : Principles of Managerial Finance Harper Row, New York.
 Prasanny Chandra: Financial Management Theory and Practice Tata McGraw Hill,
New Delhi.

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UNIT 3: FINANCIAL STATEMENT ANALYSIS

3.0 AIMS AND OBJECTIVES

After going through this unit, you shall be able to:

3.1 FINANCIAL STATEMENTS

II. Income statement:

3.2 IMPORTANCE OF FINANCIAL STATEMENTS

3.3 USERS OF FINANCIAL STATEMENTS

The following are interested in financial statements

3.4 FINANCIAL ANALYSIS MEANING AND IMPORTANCE

Financial statement analysis is a process of synthesis of summarization of financial statements

3.6 TYPES OF ANALYSIS

The financial analysis can be broadly divided into two

Check Your Progress –1

1. What is analysis of financial statements?

3.7 TECHNIQUES OF FINANCIAL ANALYSIS

Comparative Statements: Comparative statements are prepared to provide time perspective to

3.9 ANSWERS TO CHECK YOUR PROGRESS

1. I. Analysis is a process of summarization of financial statements with a view to getting an

3.10 MODEL EXAMINATION QUESTIONS

1. State the objectives of financial statements.

 Kuchhal S.C. : Financial management, Chaitanya Publishing House Allahabad.

4.0 AIMS AND OBJECTIVES

After reading this unit, you will be able to:

4.2 MEANING OF RATIO AND RATIO ANALYSIS

4.3 IMPORTANCE OF RATIO ANALYSIS

4.4 LIMITATIONS OF RATIO ANALYSIS

Ratios are meaningless, if detached form their source.

These limitations, to a considerable extent, can be eliminated or corrected:

4.5 CLASSIFICATION OF RATIOS

Financial ratios may be classified in various ways.

Balance Sheet ratios, or Income Statement ratios and combined ratios.

Check Your Progress –1

i) How can you classify the Ratio?

4.6 LEVERAGE RATIOS OR CAPITAL STRUCTURE RATIOS

Interpretation of Debt-Equity ratio

2. Debt to Total Capital Ratio

Gross Fixed Assets to Shareholders’ Funds

From the following balance sheet calculate the leverage ratios:

Debt to Total Capital Ratio

Given below is the Balance Sheet of a firm as on March 31, 2000

Long term debt

1. What does Debt-equity ratio reveal?

1. Interest Coverage Ratio

2. Dividend Coverage Ratio

3. Total Coverage Ratio or Fixed Charges Coverage

Check Your Progress –3

1. What for interest coverage ratio useful?

4.8 LIQUIDITY RATIOS

Assets Birr Liabilities & Capital Birr

The quick ratio is calculated by dividing quick assets by current liabilities:

1. Give two examples of liquidity ratios.

4.9 ACTIVITY RATIOS

1. Total Assets Turnover Ratio

2. Capital Employed Turnover

3. Fixed Assets – Turnover Ratio

5. Working Capital Turnover

6. Stock Turnover or Inventory Turnover

Receivable turnover is calculated by dividing credit sales by average receivables

8. Average Collection Period